After much discussion and controversy, a decision.
The Securities and Exchange Commission today announced that it has adopted its much-awaited rules on the role of independent directors of investment companies. Release Nos. 33-7932, 34-43786, IC-24816 (Jan. 2, 2001).
As proposed, the salient provision of the proposal is a requirement that, for funds relying on any of 10 commonly-used exemptive rules (most notably Rule 12b-1), independent directors must constitute a majority of the directors, and those directors must select and nominate any other independent directors. In addition, if funds relying on those exemptive rules choose to have their independent directors represented by counsel, the counsel must be independent.
Funds are not required to take advantage of the exemptive rules, but the message that they are expected to meet these standards is clear, and the adopting release also indicates that future exemptive orders likewise may be conditioned on standards of director independence.
The requirement that counsel (if any) be independent was by far the most controversial provision in the original proposal, largely because the proposed independence standards were perceived to be so onerous. Funds are not required to retain counsel for their independent directors, and many smaller funds choose to forgo this expense, but funds retaining counsel for their independent directors and complying with the exemptive rules must have independent counsel.
The rules as adopted continue to set forth a rigorous standard of independence, but give the independent directors more flexibility in addressing that standard. Counsel is independent if, in part,
A majority of the disinterested directors reasonably determine in the exercise of their judgment (and record the basis for that determination in the minutes of their meeting) that any representation by the person of the company’s investment adviser, principal underwriter, administrator (“management organizations”), or any of their control persons, since the beginning of the fund’s last two completed fiscal years, is or was SUFFICIENTLY limited that it IS UNLIKELY TO adversely affect the professional judgment of the person in providing legal representation to the disinterested directors . . . .
Rule 0-1(a)(6)(i)(A). The rule as proposed stated flatly that either the independent counsel would not have represented the management organizations (or their control persons), or the independent directors must find that the representation “is or was SO limited that it WOULD NOT adversely affect the person’s ability to provide impartial, objective, and unbiased legal counsel.” This standard, especially in light of the discussion in the release, seemed to contemplate that counsel would not be independent unless any conflicts were only remote or minor.
The adopting release emphasizes the SEC‘s reliance on the independent directors’ judgment and explicitly disavows the discussion in the proposing release. The release also gives guidance on how the SEC expects the independent directors’ judgment to be exercised (footnotes omitted):
In determining whether a counsel is an “independent legal counsel” under the rule, the judgment of the directors is not unbounded; it must be reasonable. The independent directors should consider all relevant factors in evaluating whether the conflicting representations are “sufficiently limited.” For example, independent directors should consider (i) whether the representation is current and ongoing; (ii) whether it involves a minor or substantial matter; (iii) whether it involves the fund, the adviser, or an affiliate, and if an affiliate, the nature and the extent of the affiliation; (iv) the duration of the conflicting representation; (v) the importance of the representation to counsel and his firm (including the extent to which counsel relies on that representation economically); (vi) whether it involves work related to mutual funds; and (vii) whether the individual who will serve as legal counsel was or is involved in the representation. Applying these factors, we do not believe that independent directors could ordinarily conclude that a lawyer whose firm simultaneously represents the fund’s adviser and independent directors in connection with matters as important to fund shareholders as the negotiation of the advisory contract or distribution plan, or other key areas of conflict between the fund and its adviser, is an “independent legal counsel.”
(Footnote 53 notes, however, that independent directors may conclude that representation of an administrator or sub-adviser does not impair independence.)
While the proposed rule only explicitly required a one-time determination of independence, the rule as adopted requires the independent directors to revisit the determination annually. The basis for the determination must be recorded in the board’s minutes, but can be based on counsel’s representations. If the counsel does begin to represent a management organization, there is a three-month grace period of deemed independence, after which the independent directors must either make a new finding of independence or terminate the counsel relationship.
The adopting release notes that the SEC does not intend to regulate the legal profession, and presumably the grace period would not be available if the applicable code of legal ethics required counsel to withdraw.
The other, less controversial provisions of the proposal were largely adopted as proposed, with minor amendments. However, in response to extensive and anguished pleas from independent directors, their disclosure requirements have been cut back to a relatively more manageable level.
The new rules generally become effective on February 15, 2001. However, the compliance date for the disclosure requirements is January 31, 2002, and the compliance date for the director independence standards is July 1, 2002.
Copyright 2000, John M. Baker, Esq., Stradley, Ronon, Stevens & Young, LLP, 1220 19th Street, N.W., Suite 700, Washington, DC 20036 – (202) 822-9611- Fax (202) 822-0140 This article was originally posted to the FundLaw List, http://www.egroups.com/group/fundlaw. To subscribe to FundLaw, send a blank e-mail to email@example.com
Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.
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